Posted by James Financial Services Inc

Pre-Tax Rate of Return

Pre-Tax Rate of Return

What Is the Pre-tax Rate of Return?

The pre-tax rate of return is the return on an investment that does not include the investor's taxes. Because people have different tax situations and different investments attract different levels of taxation, the pre-tax rate of return is the most cited investment measure in the financial world.

The pre-tax rate of return can be contrasted with the pre-tax return.


Key Points to Note

  • Allows comparison between different asset classes, as different investors may be subject to different levels of taxation.

  • It is generally equal to the nominal rate of return and is the most appreciated or appreciated return on investment.

  • The pre-tax rate of return does not take into account capital gains or dividend taxes, such as the after-tax rate.


What does the pre-tax rate tell you?

The pre-tax rate of return is the profit or loss of an investment before tax is taken into account. The government collects investment taxes on additional income from the maintenance or sale of investments.

Capital gains tax applies to securities sold for profit. Dividends received on shares, and accrued interest on securities are also taxed at the end of a given year. Since dividends on shares may be taxed at a different level from capital gains or interest income, the pre-tax rate of return allows a comparison between different asset classes. While the pre-tax rate of return is an effective comparison tool, the most important thing for investors is the after-tax return rate.


How to calculate the Pre-tax Rate of Return

The pre-tax rate of return is calculated as the after-tax rate of return divided by one, minus the tax rate.


Example of using the Pre-tax Rate of Return

For example, suppose a person obtains a 4.25% reporting rate for ABC shares and is subject to a 15% income tax. Therefore, the pre-tax rate of return is 5% or 4.25%/(1 - 15%).

For a tax-free investment, the rates of return before and after taxes are the same. Suppose a municipal bond, the exempt bond from XYZ, also has a pre-tax return of 4.25%. Therefore, the XYZ bond would have the same after-tax rate of return as the ABC share.

In this case, an investor can choose the municipal bond for its higher degree of security and for the fact that its after-tax return is the same as for the most volatile share, even if it has a rate of return—more before tax.

In many cases, the pre-tax rate of return is equal to the rate of return. Consider Apple, where holding stocks for 2018 would have generated 28.4%, which is the pre-tax return and the rate of return. If an investor had calculated the net tax rate of return for Apple's return using a 15% capital gains tax rate would be 24.14%. If we had the tax rate and the after-tax return, we would calculate the pre-tax return with the formula 24.14% / (1 - 15%).

Pre-tax vs. After-Tax Returns

Although pre-tax rates of return are more often represented or calculated, high-income corporations and investors are still very interested in after-tax returns. Indeed, the tax rate can significantly impact the decision-making process, rather than investing while maintaining the investment.

Pre-tax returns take into account taxes, especially capital gains taxes, unlike pre-tax taxes. The rate of return is generally not shown as an after-tax amount because each investor's tax situation varies.


Limitations on the use of the pre-tax rate of return

The pre-tax return is fairly easy to calculate and generally matches what is shown when analyzing an investment, be it an ETF, a mutual fund, a bond, or an individual title. However, it is out of the question that taxes may be paid on profits or earnings.


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